The Right Accounting Method for Your Business
Every small business — whether a respected local mom-and-pop retailer, a startup tech company, or an online venture — has accounting and bookkeeping responsibilities, including selecting the accounting method that works best for them. If you’re new to small business ownership, you might not even realize that there are multiple ways to keep tabs on your company’s finances.
Don’t worry, though, that’s where this guide comes in. As you keep reading, you’ll learn more about two common business accounting methods, and get helpful advice for choosing the right one for your business.
What are the most popular business accounting methods?
The two most popular business accounting methods are the cash method and the accrual method. As with anything, there are pros and cons to both tactics. Let’s take a look at what distinguishes each of them, and how to determine which is the best fit for your company’s needs.
First, you need to understand that each of the accounting methods is a way to track your incoming and outgoing money.
Fundamentally, the biggest difference between these two accounting techniques is whether you track revenues and expenses when they are actually in (or out) of hand or when they are billed. While there are many factors you’ll need to consider before choosing a method for your small business, evaluating the following will help you:
The size of your business
Your business’s future growth projections
Whether you are a sole proprietor or a corporation/publicly traded company
Whether you have (or plan to have) investors involved in your business
While most sole proprietors and small businesses have the freedom to choose the accounting method that they feel most comfortable with, companies that have investors will likely need to use the method that their investors want them to based on a vote.
It’s also worth noting that publicly traded companies earning more than $25 million in gross revenue per year are required to use the accrual accounting method.
With that understanding, let’s take a closer look at the two methods.
Cash Method
The cash method records revenue on the date that payment for goods or services is received, and expenses on the date that an invoice for goods or services is paid. This is the easiest way to keep track of cash flow. Business owners using this method are able to skip steps such as journal entries and are also able to wait to pay taxes on revenue until payment is actually received. This method is ideal for freelancers and contractors, especially if clients are slow to pay. It also works well for new business owners, who are just learning the ins and outs of bookkeeping.
Accrual Method
The accrual method records revenue at the time that a service or product is sold rather than when it is paid. This accounting option subsequently expenses on the day that a transaction is billed rather than on the day that it is paid, providing business owners with a high-level sense of their balance sheet. It also affords business finance specialists with the ability to be proactive in how they pay their bills to maximize cash flow. Though this method is more complicated, it is preferred by most accounting professionals because it provides a true sense of a business’s financial health.
Businesses that use the accrual method of accounting have the disadvantage of having to pay taxes on sales that may not have been paid, so it is essential that business owners or their accountants know the status of all incoming cash and accounts receivables. Even with this downside, accrual accounting is typically the right method for growing businesses that are looking to expand, hire additional employees, or who are seeking financing or investors.
Hybrid accounting
Hybrid accounting represents a combination of the two methods listed above. It is most appropriately used by businesses that stock inventory, as it allows them to track the cash coming in and going out of the business for products or services on a cash basis – but to track inventory using the accrual method. Though this combination offers significant advantages, it is a complicated approach that requires assistance from an experienced bookkeeper, either in-house or from a reputable third-party financial institution.
No matter which small business bookkeeping method you eventually choose, it is important that you take a thoughtful approach to making your selection. Whichever technique you choose will be the one that you are required to stick with for at least one year. You are not permitted to switch midstream, though you can adjust in a new tax year.
If you need assistance in choosing the right accounting method for your business, or would like to learn more about our comprehensive bookkeeping services, contact your bookkeeper or tax preparer today!
Not Even Celebrities Are Immune to Issues With Their Taxes
There's an old saying in life that reminds us "the only things that are certain are death and taxes." It seems that, occasionally, some celebrities seem to forget that second part.
It's true. Just because you've got the number one movie at the box office, or just because you've sold millions of albums over the course of your career, doesn't mean that Uncle Sam isn't paying attention. In fact, the IRS seems to be particularly interested in high net worth individuals like this because they A) have significant public profiles, and B) tend to bring in huge sums of money every year. It doesn't take a genius to figure out that they're watching those returns closely.
All told, there are a number of notable instances where celebrities ran into issues with their taxes - all of which we can learn a little from.
Celebrities and Taxes: A Match Made in Heaven
One notable instance of a celebrity running into problems with the IRS takes the form of the late legendary comedian George Carlin.
During the 80s, Carlin's career was at a crossroads. He was in the process of transitioning from one type of comedy to the next and was struggling. It was also around this time that he stopped filing taxes - according to a recent HBO documentary on the subject, he failed to do so for three years in a row. It wasn't long before the IRS came knocking at the door, demanding what they were owed. In the documentary, it is revealed that they even threatened to take his house away multiple times. Luckily, he was able to rectify the situation but it was certainly still scary for the funnyman.
Speaking of the 1980s, those of us who are old enough will remember that it was a period of time during which fitness guru Richard Simmons seemed to be... well, everywhere. He was on TV. He was in magazines. He couldn't have been more popular.
Flash forward to the 2000s and it was reported that he owed about $24,000 in back taxes between 2007 and 2015. It got so bad that the IRS even placed a tax lien on not only his businesses, but also his properties as well.
Next up we have O.J. Simpson, the athlete who is famous for his incredible football career (... and that other thing, but let's not get into that right now). At one point, it was revealed that Simpson hadn't actually paid any taxes since 2007 - and the amount that he owed totaled nearly $180,000. There's no actual word on whether the money was paid, but given the plethora of other legal issues that Simpson was/is facing, it's safe to say that this one may not be high on his list of priorities.
Film actor Wesley Snipes - he of "Blade" and "Money Train" fame - also famously had a run-in with the IRS several years ago. This is kind of a weird one - Snipes claimed at the time that, because of an organization he belonged to, he didn't actually have to pay taxes at all. It seems that he thought he'd discovered some kind of loophole in the system that he was ready and willing to take advantage of.
Of course, he was wrong. According to multiple reports, it seems that Wesley Snipes never actually filed any tax returns on the money that he made between 1999 and 2006. That may seem brazen, and especially so when you consider that he made about $38 million during that period of time. He ended up spending three years in jail for not paying the $7 million in taxes that he owed and was eventually released in 2013.
In the 1990s, country singer Willie Nelson also had tax problems. At one point, he owed about $32 million and the IRS seized much of his property in order to pay for it. Allegedly, the issue stemmed from shady accounting practices on behalf of someone he hired. His accountant tried to put his money in various tax shelters that turned out to be fraudulent. Let that be a lesson to all of us: always be careful who you hire and make sure they can do what they say they can.
Last but not least we arrive at who is perhaps the most famous tax cheat of all time: Al Capone. During prohibition, Al Capone ran the mob in Chicago with an iron fist. He was making endless amounts of money through some truly nefarious tactics. In addition to wielding power, he'd made a legitimate fortune - all of which he failed to report to the IRS.
Naturally, you'd think the government would want to go after him on the whole "being a notorious gangster" thing, but that proved to be harder than it sounded. So what did they do? They went after him for the $215,000 in back taxes that he owed.
This approach proved to be so successful that they were able to put him away for 11 years, breaking his rule of the city forever.
In the end, let this be a lesson to all of us: it's not just common folks who run into trouble with the IRS every now and again, even though it may often seem like that. So the next time you get audited, or get a bill in the mail saying that you ultimately owe more than you thought you did, just remember: some of the biggest names in entertainment have been in the exact same situation that you are. It might not provide total comfort with what is going on, but it should surely help.
If you'd like to find out more about how to avoid issues with your taxes so that you don't wind up like the aforementioned celebrities, or if you just have any additional questions you'd like to discuss with an expert in a bit more detail, please don't delay - contact your tax preparer’s office today!
Tax Tips for Recently Married Taxpayers
This is the time of year for many couples to tie the knot. Besides calling to update your tax office after your marriage is complete, here are some post-marriage tips to help you avoid stress at tax time.
Notify the Social Security Administration − Report any name change to the Social Security Administration so that your name and SSN will match when filing your next tax return. Informing the SSA of a name change is quite simple. File a Form SS-5, Application for a Social Security Card at your local SSA office. The form is available on SSA’s Web site, by calling 800-772-1213, or at local offices. Your income tax refund may be delayed if it is discovered your name and SSN don’t match at the time your return is filed.
Notify Those Paying You as a Contractor – If you are a self-employed sole proprietor filing your business income and expenses on a Schedule C, and you have a different name now that you are married, notify anyone who has been issuing you a Form 1099-NEC under your Social Security number about the name change. This will prevent a mismatch with the IRS.
Notify the IRS − If you have a new address, you should notify the IRS by sending in a completed Form 8822, Change of Address. If your state has an income tax, also notify the appropriate tax agency.
Notify the U.S. Postal Service − You should also notify the U.S. Postal Service when you move so that any IRS or state tax agency correspondence can be forwarded.
Review Your Withholding and Estimated Tax Payments − If both you and your new spouse work, your combined income may place you in a higher tax bracket, and you may have an unpleasant surprise when we prepare your joint return for the first time. On the other hand, if only one of you works, filing jointly with your new spouse can provide a significant tax benefit, enabling you to reduce your withholding or estimated payments. In either case, it may be appropriate to review your withholding (W-4 status) and estimated tax payments, if any, for the year to make sure that you are not going to be under-withheld and that you don’t set yourself up to receive bad news for the next filing season. Even if no adjustment is needed with your tax withholding, you will still need to advise your employer of your new marital status and name change, if applicable.
Notify the Marketplace – If you or your spouse have health insurance through a government Marketplace (Exchange), you must notify the Marketplace of your change in marital status. If you were included on a parent’s health insurance policy through a Marketplace, then the parent must notify the Marketplace. Failure to notify the Marketplace can create tax filing problems.
If you have any questions about the impact of your new marital status on your taxes, please contact your tax preparer soon!
Forgot Something on Your Tax Return? It’s Not Too Late to Amend the Return
If you discover that you forgot something on your tax return, you can amend that return after it has been filed. The need to amend can include a number of issues:
Receiving an unexpected or amended K-1 from a trust, estate, partnership, or S-corporation.
Overlooking an item of income or receiving a late or corrected 1099.
Forgetting about a deductible expense.
Forgetting about an expense that would qualify for a tax credit.
These are among the many reasons individuals need to amend their returns, whether it is for the just-filed 2021 return or prior year returns.
Here are some key points when considering whether to file an amended federal (Form 1040X) or state income tax return.
1. If you are amending for a refund, you should be aware that refunds generally won’t be paid for returns if the three-year statute of limitations from the filing due date has expired. For example, the statute of limitations for the 2021 return will generally expire on the April filing due date for 2025. Some states have a longer statute.
2. Generally, you do not need to file an amended return to correct math errors. The IRS or state agency will automatically make those corrections. Also, do not file an amended return because you forgot to attach tax forms such as W-2s or schedules. The IRS or state agency will send a request asking for the missing forms.
3. If you are filing to claim an additional refund, we should wait until you have received your original refund before filing Form 1040X.
4. If you owe additional tax, file Form 1040X and pay the tax as soon as possible to limit interest and penalty charges that could accrue on your account. Interest is charged on any tax not paid by the due date of the original return, without regard to extensions.
5. When amending multiple paper filed returns, send them in separate envelopes. Sometimes when filed together, they are mistaken for a single return, and the additional returns filed in the same envelope are not processed.
6. If the changes involve a new schedule or form that wasn’t part of the original return, it must be completed and included with the amended return. And if there are changed forms, they must be included as well. In addition, it may be appropriate to include documentation related to the changes to avoid subsequent correspondence from the IRS or state agency.
7. A detailed explanation of the changes must also be included. This is required to explain to the government’s processing staff the reason for the amendment. An insufficient explanation can lead to additional correspondence and delays.
8. Depending on why an amended federal return is required, it may be necessary to amend your state return. However, if the federal amendment is filed to claim or correct a tax credit that the state does not have, no state amended return will likely need to be filed. In most other circumstances, we will need to amend the state return as well as the federal.
An amended return can be more complicated than the original, so please see your tax preparer for assistance in with an amended return.
Is Your Will or Trust Up to Date?
When was the last time you or your attorney reviewed or updated your will or trust? If it was some time ago before the passage of substantial tax law changes over the past few years, your documents may be out of date. Among the many changes was a substantial revision to the estate tax exclusion.
No doubt your will or trust was prepared with not just estate taxes in mind but so that your assets will be distributed after your death according to your wishes. However, certain events besides the tax laws being revised can cause these documents to become outdated.
Life’s ever-changing circumstances make estate planning an ongoing process. If you don’t keep your will or trust up to date, your money and assets could end up in the wrong hands. That’s why a periodic review of your will or trust is an essential part of estate planning. Here is a partial list of occurrences that could cause your will or trust to be outdated:
Your marital status has changed.
Your heirs’ marital status has changed.
You have relocated to another state.
You’ve had or adopted children.
Your children are no longer minors.
Your children are now mature enough to handle their own financial matters.
Your assets have significantly changed in value.
You have sold or acquired a major asset or assets.
Your personal representative (executor, trustee) has changed.
You wish to delete or add heirs.
Your health status has changed.
Estate laws have changed.
Are your named beneficiaries up to date on your life insurance policies, IRA accounts, and pension plans? For example, did you forget to remove your ex-spouse or a deceased relative as your beneficiary?
You should never overlook or put off these issues because once you pass on, it will be too late to make changes.
If you have questions about how your changed circumstances may impact your estate taxes, please give this office a call.
Summer Employment for Your Child
Summer is here, and your children may be working a summer job. The standard deduction for single individuals increased from $12,550 in 2021 to $12,950 in 2022, meaning your child can now make up to $12,950 from working without paying any income tax on their earnings.
In addition, they can contribute the lesser of $6,000 or their earned income to an IRA. If they contribute to a traditional IRA, they could earn up to $18,950 tax free, by combining the standard deduction and the maximum allowed deductible contribution to an IRA for 2022 of $6,000. However, looking forward to the future, a Roth IRA with its tax-free accumulation and distributions would be a better choice. But the contributions to a Roth IRA are not deductible.
Even if your child is reluctant to give up any of their hard-earned money from their summer or regular employment, if you have the financial resources, you could gift them the funds to make the IRA contribution, giving them a great start and hopefully a continuing incentive to save for retirement.
With vacation time just around the corner and employees heading out for their summer vacations, if you are self-employed, you might consider hiring your children to help out in your business. Financially, it makes more sense to keep the family employed rather than hiring strangers, provided, of course, that the family member is suitable for the job.
Rather than helping to support your children with your after-tax dollars, you can instead hire them in your business and pay them with tax-deductible dollars. Of course, the employment must be legitimate and the pay commensurate with the hours and the job worked. A reasonable salary paid to a child reduces the self-employment income and tax of the parents (business owners) by shifting income to the child.
Example: Let’s say you are in the 24% tax bracket and own an unincorporated business. You hire your child (who has no investment income) and pay the child $16,000 for the year. You reduce your income by $16,000, which saves you $3,840 of income tax (24% of $16,000), and your child has a taxable income of $3,050, $16,000 less the $12,950 standard deduction, on which the tax is $305 (10% of $3,050).
If the business is unincorporated and the wages are paid to a child under age 18, the pay will not be subject to FICA (Social Security and Medicare taxes) since employment for FICA tax purposes doesn’t include services performed by a child under the age of 18 while employed by a parent. Thus, the child will not be required to pay the employee’s share of the FICA taxes, and the business won’t have to pay its half either.
Example: Using the same information as the previous example, and assuming your business profits are $130,000, by paying your child $16,000, you not only reduce your self-employment income for income tax purposes, but you also reduce your self-employment tax (HI portion) by $429 (2.9% of $16,000 times the SE factor of 92.35%). But if your net profits for the year were less than the maximum SE income ($147,000 for 2022) that is subject to Social Security tax, then the savings would include the 12.4% Social Security portion in addition to the 2.9% HI portion.
A similar but more liberal exemption applies for FUTA, which exempts from federal unemployment tax the earnings paid to a child under age 21 while employed by his or her parent. The FICA and FUTA exemptions also apply if a child is employed by a partnership consisting solely of his or her parents. However, the exemptions do not apply to businesses that are incorporated or a partnership that includes non-parent partners. Even so, there's no extra cost to your business if you're paying a child for work that you would pay someone else to do anyway.
Retirement Plan Savings. Referring to our original example, if the child had a made a traditional IRA contribution of $6,000 the taxable income and the tax would zero. So, it might be appropriate to make a Roth IRA contribution instead, especially since the child has so many years before retirement and the future tax-free retirement benefits will far outweigh the current $305 savings. Of course, some children will not be thinking about retirement at their young age and may object to contributing to an IRA. If that is the case, perhaps you as the parent, or even the grandparents, can make a gift of the IRA contribution, which can grow to big bucks by the time the child reaches retirement age.
If you have questions related to your child’s employment or hiring your child in your business, please give your tax expert a call!
Life Changing Events Can Impact Your Taxes
Have you experienced one or more of the following in the last year? If so, defintely take the time to read this week’s blog!!
Marriage
Buying a Home
Having or Adopting Children
Getting Divorced
Death of Spouse
Throughout your life there will be certain significant occasions that will impact not only your day-to-day living but also your taxes. Here are a few of those events:
Getting Married – If you just got married or are considering getting married, you need to be aware that once you are married you no longer file returns using the single status and generally will file as married taxpayers filing jointly (MFJ). When you file MFJ all of the income of both spouses is combined on one return, and where both spouses have substantial income, that could mean your combined incomes could put you in a higher tax bracket. However, when filing MFJ you also benefit by being able to claim a standard deduction equal to twice that of the standard deduction for a single taxpayer. It may be appropriate for a couple planning a wedding, or even those who just got married, to estimate differences of filing as unmarried and filing married so there are no unpleasant surprises at tax filing time. It may be appropriate to adjust withholding to compensate for the MFJ status.
Be mindful that filing status is determined on the last day of the tax year, so no matter when you get married during the year you will be considered married for the entire year for tax purposes. In addition, where a spouse is changing names the Social Security Administration should be notified, and the IRS should be informed of any address change by either or both spouses.
Buying a Home – Buying a home, especially your first home, can be a trying experience. Without a landlord to take care of repairs and upkeep of the property those tasks will become your responsibility as a home owner. When you rent, you are responsible for making a rental payment which is not tax deductible. On the other hand, when you own a home, in addition to being responsible for its maintenance, you have to make homeowner’s insurance, mortgage, and property tax payments. While the routine upkeep costs aren’t tax deductible, the interest on the mortgage and the property taxes you pay may be tax deductible, providing you with a significant saving in income tax. However, if the standard deduction amount for your filing status exceeds the total of all itemized deductions the law allows you to claim, you won’t get a tax benefit from the home mortgage interest and property tax payments. So, when figuring if you can afford a home be sure to take into account whether you’ll benefit from those home-related tax savings.
Also consider the long-term benefits of home ownership. Homes have generally appreciated in value in the past, so you can look forward to your home gaining value, and when you sell it, the gain up to $250,000 ($500,000 for a married couple) can be excluded from income if the property has been owned and used as your primary residence for any 2 of the 5 years just prior to the sale.
Having or Adopting Children – Besides the loss of sleep, changing diapers, middle of the night feedings, and constant attention, a new born also brings some tax benefits, including a maximum $2,000 child tax credit which can go a long way in reducing your tax liability. If both spouses work, you will no doubt incur child care expenses which can result in a maximum (can be less) credit of between $600 and $1,050 for one child or twice those amounts for two or more children. The credit amounts are based on a maximum child care expense of $3,000 for one child and $6,000 for two or more multiplied by 20 to 35 percent of the expense based upon a taxpayer’s income.
Of course, the medical expenses are deductible if you itemize your deductions but only to the extent the medical expenses exceed 10% of your adjusted gross income. Although rarely encountered, the expense of a surrogate mother is not deductible.
If you adopt a child under age 18 or a person physically or mentally incapable of taking care of himself or herself, you may be eligible for a tax credit for qualified adoption expenses you paid. The credit, which is a maximum of $14,080 for 2019, is not refundable, but if the credit is more than your income tax, you can carry over the excess and have 5 years to use up the credit. If the child is a special needs child, the full credit limit will be allowed for the tax year in which the adoption becomes final, regardless of whether you had qualified adoption expenses. The credit phases out for higher income taxpayers.
It is also time to begin planning for the child’s future education. The tax code offers two tax favored education savings accounts, the Coverdell account allowing a maximum contribution of $2,000 per year and the Qualified State Tuition plan, more commonly referred to a Sec 529 plan, which allows large sums of money to be put aside for a child’s education. There is no tax deduction for contributing to either of these programs, but the earnings from the plans are tax-free if used for qualified education expenses, so the sooner the funds are contributed the greater the benefit from tax-free earnings.
Getting Divorced - If you are recently divorced or are contemplating divorce, you will have to deal with or plan for significant tax issues such as asset division, alimony, and tax-return filing status. If you have children, additional issues include child support; claiming of the children as dependents; the child, child care, and education tax credits; and perhaps even the earned-income tax credit. Here are some details:
Filing Status – As mentioned earlier your filing status is based on your marital status at the end of the year. If, on December 31, you are in the process of divorcing but are not yet divorced, your options are to file jointly or to each submit a return as married filing separately. There is an exception to this rule if a couple has been separated for all of the last 6 months of the year, and if one taxpayer has paid more than half the cost of maintaining a household for a qualified child. In that situation then that spouse can use the more favorable head-of-household filing status. If each spouse meets the criteria for that exception, they can both file as heads of household; otherwise, the spouse who doesn’t qualify must have the status of married filing separately.
If your divorce has been finalized and if you haven’t remarried, your filing status will be single or, if you meet the requirements, head of household.
Child Support – Is support for the taxpayer’s children provided by the non-custodial parent to the custodial parent. It is not deductible by the one making the payments and is not income to the recipient parent.
Children’s Dependency – When a court awards physical custody of a child to one parent, the tax law is very specific in awarding that child’s dependency to the parent who has physical custody, regardless of the amount of child support that the other parent provides. However, the custodial parent may release this dependency to the noncustodial parent by completing the appropriate IRS form.
Child Tax Credit – A federal credit of $2,000 is allowed for each child under the age of 17. This credit goes to the parent who claims the child as a dependent. Up to $1,400 of the credit is refundable if the credit exceeds the tax liability. However, this credit phases out for high-income parents, beginning at $200,000 for single parents.
Alimony – The recent tax reform also impacts the tax treatment of alimony. For divorce agreements that were finalized before the end of 2018, the recipient (payee) of the alimony must include that income for tax purposes. The payer in such cases is allowed to deduct the payments above the line (without itemizing deductions); this is technically referred to as an adjustment to gross income. The recipient who includes this alimony income can treat it as earned income for purposes of qualifying for an IRA contribution, thus allowing the recipient to contribute to an IRA even if he or she has no income from working. Get rid of bullet symbol for next paragraph
For divorce agreements that are finalized after 2018, alimony is not deductible by the payer and is not taxable income for the recipient. Because the recipient isn’t reporting alimony income, he or she cannot treat it as earned income for the purposes of making an IRA contribution.
Tuition Credit – If a child qualifies for either of two higher-education tax credits (the American Opportunity Tax Credit [AOTC] or the Lifetime Learning Credit), the credit goes to whoever claims the child as a dependent even if the other spouse or someone else is paying the tuition and other qualifying expenses.
Death of Spouse - Losing a spouse is difficult emotionally, and unfortunately, can be accompanied by a number of tax issues that may or not apply to the surviving spouse. Here is an overview of some of the more frequent issues:
Filing Status – If a spouse passes away during the year, the surviving spouse can still file a joint return for that year if the surviving spouse has not remarried. However, after the year of death the surviving spouse will no longer be able to jointly file with the deceased spouse and will have to use a less favorable filing status.
Notification – If the deceased spouse is receiving Social Security benefits the Social Security Administration must be immediately notified. This would also be true of pensions and retirement plans of the deceased spouse.
Estate Tax – Where the deceased spouse’s assets and prior reportable gifts exceed the current lifetime inheritance exclusion ($11.4 million for 2019) an estate tax return may be required. However, the lifetime inheritance exclusion can be changed at the whim of Congress. Even when an estate tax return isn’t required because the value of the deceased spouse’s estate is less than the exclusion amount, it may be appropriate to file the estate tax return anyway, as there could be an impact on the estate tax of the surviving spouse when he or she passes.
Inherited Basis – Under normal circumstances the beneficiary of a decedent’s assets will have a tax basis in those assets equal to the fair market value of the assets on the date of death. Thus, generally a qualified appraisal of the assets is required. However, for a surviving spouse this can be more complicated depending upon whether the state of residence is a community property state and how title to the property was held.
Changing Titles – The title to all jointly held assets needs be changed into the survivor’s name alone to avoid complications in the future.
Trust Income Tax Returns – Many couples have created living trusts that, while they are both alive, don’t require a separate tax return to be filed for the trust and can be revoked. But upon the death of one of the spouses, this trust may split into two trusts, one of which remains revocable and the other becomes irrevocable. A separate income tax return for the latter trust will usually have to be prepared and filed annually.
These are just a few of the issues that must be addressed upon the death of a spouse, and it may be appropriate to seek professional help.
If you have questions about the tax impact of any of your life changing situations, be sure to give your tax preparer a call with any questions or concerns!
Why Proactive Planning is More Important Than You Realize
There's an old saying that reminds us "if you fail to plan, you plan to fail." Whoever coined that phrase was talking about the world of small business accounting whether they realized it or not.
Financial and tax literacy aren't just an important part of running a business. They're literally the foundation upon which everything else is built. Tax literacy helps to make sure that you're not only taking care of your obligations but that you're not paying more money than you should ultimately have to. Financial literacy helps to avoid problems like cash flow issues which could cause even a seemingly successful business to close prematurely.
These are also important concepts to know for individuals, too. It helps avoid problems like not budgeting properly, they can help you understand the true impact of inflation and more. All of this is in the name of avoiding common problems that typically hold people back.
But the thing to understand is that these are not skills that you're born with - you have to be proactive about learning them. You also want to make sure that you have the right partner by your side to help make this process as easy as possible.
The Power of a Well-Laid Plan
One of the major reasons why planning is so crucial in this context is because it helps avoid one of the single biggest problems that both businesses and individuals often face: not budgeting properly.
Indeed, the lack of a sound (and realistic) budget is often one of the major contributors to money problems for most people. When no semblance of a plan is in place, it's far too easy to overspend. It's also likely that you're not paying nearly as much attention to your finances as you should be. This in turn leads to a significant amount of financial stress, which isn't something that you can just get rid of overnight.
What people don't realize is that by coming up with a plan and creating that budget, it can actually put them closer to their goals - not farther away from them. Yes, it may take a bit of additional time to make that big purchase, but you're not going to overspend. You're not going to use funds that were allocated for something more important. You can also see the progress you've made and how far you have left to go, which can help create a much-needed perspective on the entire situation.
Another way in which financial and tax literacy - along with planning - can help both businesses and individuals comes down to avoiding the dreaded trap of "living paycheck to paycheck." It's something that far too many private citizens know all about, and it can even rear its ugly head for business owners, too, albeit in a slightly different context.
For individuals, it's safe to say that they're up against a number of hurdles in addition to a lack of financial literacy. The current job market is nothing if not rough. Economic uncertainty abounds, especially given everything going on right now with the war in Ukraine.
But at the same time, you have to start somewhere - and that "somewhere" involves gaining the knowledge you need to take control of your finances. Not everyone has the opportunity to earn extra income - like by picking up a second job or by moving to a new position that pays more.
Instead, try prioritizing your interests in a way that better aligns with the funds you do have available. Sure, private citizens may want to travel more or purchase a larger home, but your plan may illustrate to you that it just isn't in the cards right now.
The same is true of businesses - you may want to aggressively expand into a new market, but doing so without some type of plan in place is little more than a recipe for disaster.
In the end, financial and tax literacy are two of the most important elements of our society that people just aren't paying enough attention to. But by making an effort to understand your situation and the world around you, you'll find yourself in a much better financial position than the one you were in when you started.
If you'd like to find out more information about why proactive planning is far more important than you may realize, or if you just have any additional questions that you'd like to go over with someone in a bit more detail, contact your tax preparer for this tax year NOW!
Highlights of College Savings Plans (Sec 529 Plans)
The Qualified State Tuition Plan, often referred to as the Sec 529 Plan, is a tax-beneficial incentive for parents, grandparents, and others to save money for an individual’s future college tuition and fees. There is no federal tax deduction for making contributions. But the tax benefit of these plans is that the earnings within the plan accumulate tax-deferred and then are tax-free when withdrawn if used for college tuition and related qualified expenses. Let’s take a simplified example.
Example: Jo’s parents establish a 529 plan when she is age 5, and contribute $10,000 to the plan. The $10,000 is invested in mutual funds that pay dividends of $400 per year. The tax on the dividends is deferred until the time when funds are withdrawn from the plan, and only payable if the distribution isn’t used for eligible education expenses. Let’s say that Jo enters college in 13 years and with the dividends earned over those years and an increase in the value of the original $10,000 to $15,000, the account is worth $20,200. Jo’s tuition and related expenses for her first semester is $25,000. The entire $20,200 is withdrawn to pay those expenses, so none of the dividends received and none of the $5,000 gain in the value of the account will be taxable. If Jo’s parents were in a 24% tax bracket, the tax savings by investing in the 529 plan compared to putting $10,000 in a regular brokerage account will be at least $1,530. The benefit would be compounded if more than $10,000 was contributed to the 529 plan.
Contributions - To maximize the tax benefits of a plan, it should be established for a child as soon after birth as possible when funds are available for contribution. For tax purposes, there is no limit on the amount that can be contributed, but contributions are considered gifts and each individual contributing to a plan would have to file a gift tax return if the gift exceeds the annual inflation-adjusted gift tax exclusion, which is $16,000 for 2022 (up from $15,000 for years 2018 through 2021).
A special gift provision permits a contributor to contribute up to 5 times the annual gift tax exclusion amount to a qualified tuition account in a single year and treat the contribution as having been made over the five-year period beginning with the calendar year in which the contribution is made. Why would someone want to do this? Because by front-loading the contributions, they would accelerate the accumulation of earnings within the account. When making 5 years’ worth of 529 plan contributions in one year, a gift tax return is required in the year of contribution. If the contributor dies within the 5-year period, any amount contributed that is applicable to the years within the five-year period remaining after the year of the contributor’s death are able to be included in the contributor’s gross estate for estate tax purposes.
Although the income and gift tax laws don’t cap how much can be contributed to a qualified tuition plan, the 529 plans do limit the maximum amount that can be contributed per beneficiary based on the projected cost of a college education, and the maximum amount will vary between plans, though most have limits in excess of $200,000, with some topping $475,000. Generally, once an account reaches that level, additional contributions cannot be made, but that doesn’t prevent the account from continuing to grow.
Modifications – Since originating these plans, Congress has continued to modify the purpose of the plans by allowing plan funds to be used for more than just college tuition and fees. Over the years, they have allowed plan funds to be spent on additional expenses, including books, supplies, equipment, reasonable room and board, and computer technology.
More recently, the following qualified expenses were added:
Elementary and Secondary School Tuition Expenses – The Tax Cuts and Jobs Act (2017) included a provision that treats withdrawals from 529 plans for elementary or secondary school (kindergarten through grade 12) tuition expenses as qualified expenses. However, the annual withdrawal for each beneficiary is limited to $10,000 (regardless of the number of 529 plans in the beneficiary’s name). This special $10,000 amount applies only for tuition (not books, supplies, room and board, etc.) paid to public, private or religious schools.
Be Cautious – Since the greatest tax benefit and primary goal of these plans is accumulating tax-deferred investment income, which then can be withdrawn tax-free to pay qualified education expenses, using these funds too early will not achieve that desired goal. Thus, you should carefully consider whether to use the funds for elementary and secondary school education expenses or to wait and tap the account for post-secondary education, with the latter choice maximizing investment income.
Apprenticeship Expenses – The category of qualified expenses was expanded by the Secure Act to include fees, books, supplies, and equipment required to participate in registered apprenticeship programs certified by the Secretary of Labor under Sec 1 of the National Apprenticeship Act, effective for distributions made in years after 2018.
Repayment of Student Loans – Another Secure Act addition to 529 plan qualified expenses is effective for distributions after 2018 of up to $10,000–a lifetime limit–that may be used to pay the principal and interest on qualified higher education loans of the designated beneficiary or a sibling of the designated beneficiary. To prevent double-dipping, Sec 529 plan distributions used to pay interest on the education loan cannot be used for the above-the-line deduction allowed for student loan interest.
In addition to 529 plans Congress has also provided tax credits to help fund a child’s college education, though the rules for these credits aren’t entirely straight-forward. For example, one favorable twist of the tax code allows a grandparent (or others) to directly pay to the educational institution the child’s tuition without being subject to the gift limitations or reporting. On top of that, assuming the child is a dependent of their parent, the parent may qualify for a higher education credit even though the grandparent paid the tuition. The parent’s eligibility depends on their income, since the credits phase out once the adjusted gross income of the individual claiming the credit exceeds an amount based on filing status and the type of credit claimed.
If you need assistance with long-term education planning, give your tax consultant a call soon!
Writing Off Your Business Start-Up Expenses
New business owners, especially those operating small businesses, may be helped by a tax provision allowing them to deduct up to $5,000 of the start-up expenses and $5,000 of organizational costs in the first year of the business’s operation. These types of expenses not deductible in the first year of the business must be amortized (deducted) over 15 years. If a taxpayer who incurred start-up expenses does not make the election, the start-up costs must be capitalized, meaning that the expenses can only be recovered upon the termination or disposition of the business.
Generally, start-up expenses include all expenses incurred to investigate the formation or acquisition of a business or to engage in a for-profit activity in anticipation of that activity becoming an active business. To be eligible for the election, an expense must also be one that would be deductible if it were incurred after the business actually began. An example of a start-up expense is the cost of analyzing the potential market for a new product.
Qualifying Start-Up Costs – A qualifying start-up cost is one that would be deductible if it were paid or incurred to operate an existing active business in the same field as the new business, and the cost is paid or incurred before the day the active trade or business begins. Not includible are taxes, interest, and research and experimental costs.
Examples of qualified start-up costs include:
Surveys/analyses of potential markets, labor supply, products, transportation facilities, etc.;
Wages paid to employees and their instructors while they are being trained;
Advertisements related to opening the business;
Fees and salaries paid to consultants or others for professional services; and
Travel and other related costs to secure prospective customers, distributors, and suppliers.
For the purchase of an active trade or business, only investigative costs incurred while conducting a general search for, or preliminary investigation of, the business (i.e., costs that help the taxpayer decide whether to purchase a new business and which one to purchase) are qualified start-up costs. Costs incurred attempting to buy a specific business are capital expenses that aren’t treated as start-up costs.
Qualifying Organizational Cost - include fees for legal services, such as for drafting LLC documents, partnership agreements, corporate charter and by-laws; incorporation fees; temporary directors' fees; and organizational meeting costs.
Phaseout - As with most tax benefits, there is always a catch. Congress put a cap on the amount of expenses that can be claimed as a deduction under this special election. Here’s how to determine the deduction: If the expenses are $50,000 or less, you can elect to deduct up to $5,000 in the first year, plus you can amortize the balance over 180 months.
Example: Eligible start-up expenses are $6,000 and the business began on July 1, 2022. On the business’s 2022 tax return, the deduction for start-up expenses will be $5,033 ($5,000 + ($1,000/180 x 6 months)).
If the expenses are more than $50,000, then the $5,000 first-year write-off is reduced dollar-for-dollar for every dollar in start-up expenses that exceeds $50,000.
For example, if start-up costs were $54,000, the first-year write-off would be limited to $1,000 ($5,000 – ($54,000 – $50,000)), plus the remaining $53,000 of costs would be amortizable over 180 months. These limits are applied separately for the start-up and organizational costs.
The election to deduct start-up and organizational costs is made by claiming the deduction on the return for the year in which the active trade or business begins, and the return must be filed by the extended due date.
The decision to write off these expenses should take into consideration other tax benefits available in the first of year of the business, including bonus depreciation and Sec 179 expensing, the Sec 199A deduction, and the overall result in the first year of the business.
If you are starting a business, it may be appropriate to formulate a business plan in advance. Setting up an appointment with your tax advisor would definitely be beneficial to you and the business!